The Toxic Billion Dollar Goldman Sachs Bond Deal that the SEC Let Get Away

The SEC inexplicably backed off on an investigation into a disastrous Goldman mortgage bond deal.

In early 2012, the Securities and Exchange Commission had Goldman Sachs, and perhaps the rest of Wall Street, in its sights.

SEC enforcement lawyers believed they had uncovered evidence showing that Goldman had defrauded investors, misleading them into thinking a particularly toxic subprime $1.3 billion mortgage bond, Fremont Home Loan Trust 2006-e, was a safe bet. Internal Goldman emails showed that one of the bankers on the deal knew that Fremont, the loan originator, had never verified the value of the homes on which the loans in the deal were based. Worse, many of the mortgages in the deal had previously been rejected by Goldman. But this time around, a supervisor at Goldman instructed a quality assurance staff member to make “liberal assessments.” What’s more, the SEC had evidence that Goldman knew it was likely that more than 10% of the loans in the deal were credits that Goldman classified as so-called EV3s—”unacceptable risks,” or “drops.” A third party reviewer, mortgage due diligence firm Clayton, had told the bank as much. Yet nearly all of the deficient loans were waived into the deal, including one where a borrower had a debt-to-income level of 91%.

In mid-February 2012, the SEC sent Goldman a Wells notice, formally notifying the firm that the SEC was drawing up a civil fraud suit based on the deal. It would have been the SEC’s second big case against Goldman GS -0.11% in less than two years. The bank had paid $550 million to settle claims it defrauded investors in the Abacus CDO in July 2010. This second case had the potential to be a blueprint for other actions against the big banks. Goldman had 30 days to respond.

And then, nothing.

In August 2012, Goldman said in a securities filing that it had received word from the SEC that the regulator had closed its investigation and would not bring any action against the bank related to mortgage bonds. The fine Goldman had to pay? Exactly zero.

Four years later, the Goldman SEC case-that-never-was is a black eye for the SEC and offers further proof that Wall Street’s chief regulator failed to do its job in the wake of the financial crisis. Meanwhile, earlier this month, Goldman Sachs agreed to pay nearly $5.1 billion to settle claims from the Department of Justice that the bank defrauded investors in mortgage bond deals.

The DOJ settlement covers dozens of deals. But Colleen Kennedy, an assistant U.S. attorney in Sacramento and one of two government lawyers who led the DOJ’s Goldman mortgage investigation, says that one of the deals she and her colleagues looked at closely was Fremont Home Loan Trust 2006-e, the same deal the SEC had investigated. What’s more, according to a person with the knowledge of the SEC’s investigation and the DOJ’s eventual settlement with Goldman, the SEC largely had the same evidence the DOJ did. But rather than secure a billion-dollar settlement, as the DOJ did, or go to trial, the SEC dropped its case.

“There’s no question the DOJ took a much more stern stance with the banks starting in the last two years of [Eric] Holder’s tenure as U.S. Attorney General,” says John Coffee, a law professor at Columbia University. “The SEC hasn’t gotten billions from anyone.”

No one at the SEC has publicly explained what derailed the regulator’s Goldman mortgage bond investigation. And while there has been a fair amount of turnover at the SEC, the group that pursued the case and other complicated deals in the wake of the financial crisis remains largely intact.

Pointing fingers

In an email to Fortune, Mary Schapiro, the former SEC chairwoman who left the agency in late 2012, says despite the Wells notice and all the evidence that the SEC amassed against Goldman, the case never made it to her or the other commissioners. Schapiro essentially points the finger at Robert Khuzami, who was then the head of enforcement for the SEC, for dropping the ball. “You would have to ask the enforcement director at the time,” Schapiro responded. “If the staff doesn’t recommend charges, the Commission has nothing to vote on.”

Following the Wells notice, it looks like Khuzami killed the case and told Goldman it was off the hook. According to Kennedy, the case was never referred to the DOJ, which started looking at FHLT 2006-e and other deals when it began its own independent investigation of Goldman in January 2014. Khuzami left the SEC in 2013 and is now a partner at top law firm Kirkland & Ellis, where he has represented companies including Deutsche Bank.

Khuzami did not respond to Fortune’s requests for comment. Both the SEC and Goldman declined to offer comment for this story.

The SEC has levied a total of nearly $3.8 billion in fines against firms and individuals for conduct related to the financial crisis, including the $550 million settlement in the Goldman Abacus case. But that’s tiny compared to the nearly $45 billion in fines, penalties, and settlements dolled out by the government’s mortgage taskforce, which is a collaboration between the DOJ and a number of state attorneys generals, including New York’s Eric Schneiderman.

Around the same time that the SEC sent Goldman a Wells notice, it also began a similar investigation into the giant bank Wells Fargo WFC -0.71% . The SEC did get Wells Fargo to pay a $6.5 million fine for its mortgage misdeeds, which included $65,000 in illegally obtained profits. Earlier this month, Wells Fargo settled similar charges brought by the Department of Justice. This time, the bank had to shell out $1.2 billion in fines.

House Financial Services Committee Hearing On Financial Regulation
Robert Khuzami, when he served as director of the division of enforcement at the U.S. Securities Exchange Commission

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